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     Jan 12, 2011

Slippery slope to job creation
By Hossein Askari and Noureddine Krichene

Over the past decade, the profligacy of the US Federal Reserve has ended with financial chaos in the United States and in Europe, with low growth and high unemployment as the longer-term legacy.

Fed chairman Ben Bernanke, a Keynesian, vowed in 2002 to fight deflation and to stimulate employment. Accordingly, the federal funds rate was set at 1% during 2003-2004; domestic credit in the US expanded at 12% per year; the US dollar tumbled; and US external deficits deteriorated to 6-7% of GDP.

The Fed was on a mission to secure full-employment no matter


what the collateral damage. It was as if monetary policy had no effect on any variable or sector except on employment. Fed policymakers were in denial of a relationship between low interest rates and stratospheric housing prices, between low interest rates and the fall of the US dollar, or between low interest rates and external deficits.

Unfortunately, contrary to the prediction of Keynesian model of full-employment, the US economy fell into financial chaos, bankruptcies, millions of foreclosures, unprecedented fiscal deficits, and above all, mass-unemployment. Contrary to the Fedís narrow view that denies any effect of loose monetary policy except on employment, Fed monetary policy has devastated many sectors and many countries, and has fueled mass-unemployment.

In 2002, when Bernanke was appointed to the Fed's board of governors under the chairmanship of Alan Greenspan, he did not anticipate the financial and economic crises that broke out in August 2007. He appeared oblivious to the fact that such lax monetary policy would send oil prices racing from $18/barrel in 2002 to $147/barrel in 2008, housing prices doubling and tripling causing millions of foreclosures, and food prices flying to sky high levels and pushing millions into living on food stamps.

As a declared Keynesian, it would appear that Bernanke, who took over as Fed chairman in 2006, was not much interested in the long-term consequences of Fed policies, only short-term gains in employment seemed to matter irrespective of the consequences of overly expansionary fiscal and monetary policies on housing markets, asset markets, energy, food, or exchange rates.

Yet, it has been repeatedly observed during 19th and 20th centuries that cheap monetary policies invariably ended in a terrible hangover - serious economic recessions, even depressions, and widespread financial failures.

Little expertise is required to predict the consequences of overly expansionary monetary policy. Japan in 1992 was not a surprise: easy money policy in late 1980s culminated into a severe financial crisis and protracted stagnation. The faster is monetary expansion, the faster is credit expansion, and the faster and more calamitous the financial crisis and the economic recession.

Adam Smith (d 1790) and Jean-Baptiste Say (d 1832), in opposition to rapidly expansionary monetary policies, long ago established the inherent contradiction of what became known as Keynesianism. The Fed (ie the US government) wanted to achieve full-employment by setting interest rates to negative levels and printing money; this policy was self-defeating and brought financial collapse and mass unemployment. The Fed had to "TARP" the financial system with through the mechanism of the Troubled Asset Relief Program, introduced in late 2008 to buy trillions of toxic assets, and force even more unorthodox monetary policies in the name of creating jobs.

It has been the government that has caused economic disorders; it is the government that has tried to salvage the economy through the same policies that injured the economy in the first place; and it is the government that is now caught in a circular and increasingly injurious set of policies that sees inflationism as the only path to prosperity and full-employment. This is at best a slippery slope.

Bad government policies beget bad results and bad results, in turn, beget even worse policies. The Fedís low interest rates and expansionary monetary policy in 2002-2004, although meant to combat deflation and unemployment, caused commodity price inflation, housing speculation, and general bank failures in the US and Europe.

The government had to bailout banks at cost of trillion of dollars. Fiscal deficits exploded to historic levels. The Fed resorted to printing massive quantities of money to finance these deficits. Bernanke (again ie the government) had to re-inflate the economy to prevent housing prices from falling by injecting about $1.5 trillion.

Fed policies protected debtors at the expense of creditors and reduced their real debt. Interest rates were set at near-zero bound to stimulate the economy. The Fed had to create billions of dollars in new facilities to lend to subprime borrowers. Recently, realizing that core inflation was low, and therefore inconsistent with the Fedís mandate, chairman Bernanke decided to re-inflate again by injecting an additional $600 billion. This new money will permit the financing of larger fiscal deficits.

There is always a political pressure to escalate inflationism to finance fiscal deficits, protect debtors, and achieve full-employment. Keynesianism and inflationism have been likened to a drug addiction: one dose calls for stronger dose to keep the subject in high state, irrespective of the collateral damage the drug will cause to the addicts's health.

This chain of events started with overly expansionary monetary policies of 2002-2004 and kept on escalating as the financial crisis spread and the economic downturn intensified. If only the Fed had not followed these expansionary/inflationary policies in 2002-2004, then no disruption to the economy, no housing crisis, no bailouts, no mass unemployment, and no commodity price inflation would have taken place. The economy, in all likelihood, would have continued on its steady growth path of the two previous decades. Politicians and supporters have portrayed the Fed as a savior, for salutary rescue of the financial system, by printing trillions of US dollars in bailouts!

There is no let-up in the continuation of Fed policies. The Fed's balance sheet has increased to $2.4 trillion in 2010 from $0.8 trillion in 2008 and could reach $3 trillion in 2011. Expansionary monetary policy has been propitious for inflating stock prices and for exacerbating exchange rates instabilities.

US stock price indices rose by between 11% and 13% in 2010 despite economic stagnation and an unemployment rate of 9.8%. Commodity price inflation has been raging at accelerating rates. Countries like China and India are grappling with food inflation in excess of 12% per year. Food prices are escalating in almost all countries. Oil prices are again about to break again the $100/barrel mark and should keep on climbing, in turn threatening the fragile recovery; the gold price, now around $1,440 an ounce, could race upward with no bound.

Certainly, there is no economic coordination among the big powers in spite of the symbolic existence of the Group of 20. Each country will be guided by its own domestic agenda. The dollar has been depreciating and tensions are building among countries. Each will try to peg its currency to the dollar and will prevent an appreciation of its own currency. Each country will try to inflate at the same rate as the US or even higher. Such was also the landscape during the inter-war years.

Previously, the Organization of Petroleum Exporting Countries was blamed for oil shocks. However, in the past few years, the Fed has been creating its own oil shocks. The Fed is directly setting oil prices; in fact, its power extends well beyond oil prices to gold, copper, corn, rice, soybeans, coffee, cotton, tea, and practically all commodity prices. Even stock prices are directly jerked up by the Fed, beyond long-term fundamental levels.

With interest rates at near-zero, and billions of dollars injected into speculative markets, the rise of oil and food prices will have little resistance. More and more money printing will further distort prices. Many countries that are oil and food importers will see their growth stalling.

The political forces in the US are strongly supportive of inflationism as a way to combat the effects of past inflationism and bring the economy to full-employment and economic growth. This provides the Fed with a free-hand for inflating. How much can the economy can grow and create employment when subjected to oil shocks and oil price inflation? Experience has shown that the economy has invariably stalled under oil shocks; if oil shocks combine with food shocks then the economy may again suffer as as it did in 2008.

The political myopia that prevailed in 2002 still prevails in 2011. Politicians try to win electorate support in favor of these policies by promising full-employment and prosperity, but as Abraham Lincoln said, you cannot fool people all the time.

Governments are adamantly against nominal adjustment of wages or prices for clearing markets. Labor unions would oppose any downward adjustment of wages and salaries. Recently, in a Wall Street Journal article, Peter Schiff showed that housing prices were too overvalued and needed to drop significantly to ameliorate the housing sector crisis. In such a political set-up that rejects market adjustment, the unemployment problem has been simply summed up and attributed by Keynesians to demand failure.

Only if government dramatically increases spending as called for by former White House economic advisor Larry Summers, undertakes vast public works projects, reduces interest rates, and prints money, the whole problem is solved! Historically, there has not been a country that has been able to bring down mass unemployment from above 10% to full-employment at 3-4% through simple inflationism. The stagflation of the US during 1970-1982 illustrated the dramatic impotence of inflationism to bring the economy back to full-employment.

The economic prospects for 2011 will be dominated by monetary follies and fiscal profligacy. Uncertainties should be further heightened. Speculation could intensify. Exchange rate instability and currency wars may accentuate. Stock prices will be largely driven by speculative euphoria. Commodity prices will not stabilize while interest rates are at near-zero and dollar liquidity is injected without limit; commodity prices will continue to trend upward. Countries such as China and India may be slowed down by food price inflation.

Hence, 2011 could be as unorthodox as the Fedís unorthodox policies. All the while, addicts continue to see a strong and lasting recovery just around the corner!

Hossein Askari is Professor of International Business and International Affairs at the George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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